Jim Chanos on the Cycle of Frauds

The below section comes from a larger, must-read Jim Chanos interview that just popped up at Salon.com, of all places. In it, the legendary skeptic and short-selling maven talks about why frauds tend to cluster around the back-half of expansions and booms…

What do we know about the timing of frauds? When are they most likely to happen?

JC: One of our models is the Kindleberger-Minsky model, named after Hyman Minsky and Charles Kindleberger. It’s a macro model, and basically it takes a look at various market cycles. What we find is that the greatest clustering of fraud in the financial markets occurs, as you might imagine, during and immediately after the biggest bull markets. As I like to tell my students, it’s basically a period in which people suspend their disbelief. Everybody’s getting rich and it becomes increasingly easy to sell more questionable schemes and investments to investors. Typically the major frauds are uncovered or unmasked after the markets decline, for example, Bernie Madoff or Enron, when investors need money from other losses (and often these things have a Ponzi-like nature and can’t finance themselves from a self-sustaining basis) or people simply begin to build back their sense of disbelief and begin to ask tough questions that they didn’t ask during the bull market. So we do see that the fraud cycle generally does track the broader financial market cycles we see with a little bit of a lag.

Chanos teaches a course on corporate fraud at Yale. The rest of the interview is amazing, please make time for it.